Independent Contractor or Employee?
As a business owner, it is very important for you to correctly determine whether a worker who provides services to you is an employee or an independent contractor. If the person is an employee, you must withhold income taxes, withhold and pay Social Security and Medicare taxes and pay unemployment taxes on the wages you pay. On the other hand, if the person is an independent contractor, you do not need to withhold or pay any taxes on your payments to him or her. The independent contractor is responsible for paying his own income taxes, Social Security and Medicare taxes. If the person is determined to be an employee but you have treated him or her as an independent contractor, it can be a costly mistake for your business.
What is the Relationship?
Although the distinction is generally characterized as "employee vs. independent contractor", there are really four possible classifications for a worker:
- an independent contractor
- an employee (common-law employee)
- a statutory employee (certain independent contractors who, by law, are treated as employees)
- a statutory nonemployee
Many business owners mistakenly believe that they may simply choose to designate a person as an independent contractor rather than as an employee, and that is the end of the inquiry. In fact, to determine whether a person providing a service to your business is an employee or an independent contractor, you must look at the degree of control that you exercise over the person.
Control vs. Independence
The facts that must be weighed in evaluating the degree of control and independence fall into three general categories: behavioral, financial, and type of relationship. No single category is more important than the others in all situations, but the factors given are also not necessarily equal weight. In one situation certain factors may dominate the determination and in another situation those same factors may have little or no relevance to the determination.
Do the facts show that your business has a right to direct or control the worker? A worker is generally an employee when the business has the right to direct and control his work, even if the business does not actually exercise the right to direct or control how the work is done. Behavioral factors include:
Types of instructions given. A business generally gives an employee specific instructions about when, where and how to work. The instructions may include what tools or equipment to use, what workers to hire or to assist with the work, where to purchase supplies and services, what tasks must be performed by which specific individuals, and what order or sequence to follow when performing a task. Giving these types of instructions to a worker makes it more likely that the worker will be treated as an employee, rather than as an independent contractor.
Degree of instruction. The more detailed the instructions given, the greater the degree of control the business exercises over the worker. More detailed instructions make it more likely that the worker is an employee. Less detailed instructions means less control, pointing to the fact that the worker is more likely to be an independent contractor.
Evaluation systems. If the business evaluates the worker by measuring the details of how the work was performed, that indicates that the worker is an employee. If the evaluation system measures just the end result, the worker might be either an employee or an independent contractor.
Training. If the business trains the worker on how to do the job, it is strong evidence that the worker is an employee. Periodic or ongoing training about procedures and methods is even stronger evidence of an employer-employee relationship. Independent contractors, on the other hand, typically use their own methods to do a job.
How much control does the business have over the economic aspects of the worker's job? The more control the business has, the more likely that the individual is an employee. Financial factors include:
Significant investment. An independent contractor frequently has made a substantial investment in the equipment that he uses in performing his tasks. Like other factors, there's no hard and fast rule on investments in equipment. In some fields, such as construction, workers spend thousands of dollars on the tools and equipment they use and are still considered to be employees, while for some types of work performed by independent contractors, large expenditures are not required.
Unreimbursed expenses. Independent contractors are more likely to have expenses that are not reimbursed by the business.
Opportunity for profit or loss. The opportunity to make a profit, or to lose money, is an important factor. If a worker makes a significant investment in the tools and equipment he uses and if the worker has expenses which are not reimbursed by the business, there is a greater likelihood that the activity will result in a loss. Having the possibility of incurring a loss indicates that the worker is an independent contractor.
Services available to others. An independent contractor is generally free to offer his services to other businesses. Independent contractors frequently advertise, maintain a visible business location and are available to work for others in the relevant market.
Method of payment. An employee generally receives a regular wage amount on an hourly, weekly or other basis. An independent contractor is often paid a flat fee for a specific job, although it is often common in some cases to pay independent contractors hourly.
Type of relationship
How do the worker and business perceive their relationship to each other? Factors that illustrate the type of relationship perceived between the two parties generally fall into the following categories:
Written contracts. A contract may state that the worker is an employee or an independent contractor. Although this is a factor, the IRS is not required to follow the characterization contained in a contract.
Employee benefits. Businesses normally only provide employees with benefits such as insurance, pension and profit-sharing plans, paid vacation, sick days and disability insurance. The lack of these types of benefits does not necessarily mean the worker is an independent contractor, but providing these benefits is likely to indicate the worker is an employee.
Permanency of the relationship. If a business hires a worker with the expectation that the relationship will continue indefinitely into the future, rather than for a specific project or period, the IRS generally considers it to be evidence that the parties intended to create an employer-employee relationship.
Services provided as key activity of the business. If a worker provides services that are an important aspect of the business, it is often more likely that the business will have a greater degree of direction and control over those activities. This would point to an employer-employee relationship.
Weighing the factors
A business must weigh all of the above factors when evaluating whether to treat a worker as an employee or an independent contractor. It is likely that some factors will indicate that the worker is an employee, while other factors will indicate that the worker is an independent contractor. Unfortunately, weighing the factors is not a simple numerical task. Even where a majority of the factors point to one result, the smaller number of factors indicating the contrary result can be so persuasive that they carry the day.
The important thing is to look at the entire relationship of the worker to the business. Consider the degree or extent of the right of the business to direct and control the worker. Finally, carefully document each of the factors used in coming up with your determination.
If you've carefully reviewed all of the factors, and you are still unclear as to whether a worker is an employee or an independent contractor, you can file form SS-8 (Determination of Worker Status for Purposes of Federal Employment Taxes and Income Tax Withholding) with the IRS. The form may be filed by either the business or the worker. Following receipt of the form, the IRS will review the facts and circumstances outlined in the form and will officially determine the worker's status. It can take at least six months to get a determination.
Determining whether a worker is an independent contractor or an employee is a challenging task for any business. Follow these guidelines, and that task will hopefully become a little clearer.